Friday, June 12, 2009

The head of China's second-largest bank has said the United States government should start issuing bonds in yuan, rather than dollars ...

It was the first time the head of a major Chinese bank has called for the wider use of the yuan, although a chorus of senior government officials have already voiced their concerns about the stability of the dollar and have said the yuan should be used more widely ...

Guo Shuqing, the chairman of state-controlled China Construction Bank (CCB) ... is a former head of China's foreign-exchange administration, which manages the country's $1.9 trillion foreign exchange reserves ...

Two months ago, before the G20 meeting in London, Zhou Xiaochuan, the head of the People's Bank of China, the central bank, published a personal paper proposing to replace the dollar as the international reserve currency. His call came after Wen Jiabao, the Chinese premier, asked the US to guarantee the safety of China's huge pile of US debt ... [Telegraph]

Maybe the Chinese have been listening to Warren Buffett, who at the end of February in his annual letter [.pdf] to Berkshire Hathaway shareholders warned against today's "bubble" in US Treasury bonds...

When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early 2000s. But the U.S. Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary.

Clinging to ... long-term government bonds at present yields is almost certainly a terrible policy if continued for long.

If you were the Chinese government currently holding some $800 billion of US bonds, how would that make you feel?

Especially since China, for all the talk of it becoming an economic power, is still a poor country, with GDP per capita (at purchasing power parity) of only about $6,000, compared to about $47,000 for the US. So $800 billion to them is by that measure almost eight times as much as it is to us -- call it $6 trillion, in our terms. That's a lot have invested in an "historic bubble".

As long as the Chinese keep investing their money in our debt denominated in our dollars, they can lose three ways...

[] As interest rates on US debt rise from their recent historic lows, the price of US debt obligations will fall, since bond prices move inversely to interest rates.

For instance, 30-year US bonds earlier this year were paying less than 3%. If the Chinese bought any of those, and the rate on 30-year bonds returns to a much more typical 6% in the near future, the market value of those bonds will drop per $1,000 to under $600, a cool 40% decline.

[] The exchange rate value of the dollar can be expected to drop from its surge level of the financial crisis that saw it rise by almost 20% in recent months, as foreigners rushed into the dollar in the "flight to safety" to buy US debt, sharply reversing a long slide in the dollar's value that began in 2001. But now the dollar has begun going down again.

If it only goes back to where it was, the loss of the dollar value of those 3% bonds will be compounded by the corresponding loss in the value of the dollars they are valued in. Ouch. And the long-term decline in the value of the dollar may resume from there, as the US continues to run historic fiscal and trade deficits.

[] The value of the dollar itself may drop if inflation rises in coming years, as has been known to happen to the currencies of countries that run massive deficits indefinitely, as the US government now is planning to do.

Put all the above together, and you can see how the Chinese would sleep better at night if they were loaning all that money to us through bonds denominated in their currency rather than our currency.

Of course, right now they are offering that idea only as a suggestion...